Risk Management

It’s the Losses, Stupid

Driven by a drop in self-retained losses, the cost of risk dropped to a 10-year low in 1999. But watch out for higher insurance costs in 2001.
David KatzDecember 12, 2000

With their companies facing the likely prospect of higher property-casualty insurance costs in 2001, CFOs and the risk managers who toil under them may soon be handling some hot potatoes: potential losses that were previously insured. And those loss exposures— spiked by a random hurricane or a stray class- action suit—can be a good deal more volatile than the movement of the price of insurance from year to year.

Sharp rises and plunges in the cost of those retained losses, in fact, have caused a herky- jerky movement over the past three years in the average cost of risk, a benchmark of what corporations pay to fund losses, either out of their own pockets or by paying premiums to insurance companies.

For instance, a steep drop in the dollar amount of retained losses, coupled with a dip in insurance premiums, pushed the average cost of risk off a cliff to a 10-year low of $5.20 per $1,000 of revenue in 1999, the latest year studied, according to the just-released Benchmark Survey produced annually by Ernst & Young for the Risk and Insurance Management Society (RIMS).

In contrast, in 1998, losses paid for by corporate buyers themselves—including big weather-related and employee-benefit liability losses—drove the cost of risk up 9 percent, to $5.71, after it had reached a seven-year low of $5.25, according to last year’s survey.

In 1999, apparently, the risks retained by companies through deductibles and self- insurance and in captive insurance companies behaved with great moderation, producing low costs to go with premiums that have bottomed out in the long soft market for insurance companies. This picture, however, suggests that now the only direction for insurance costs to go is up.

One clear sign of higher premiums to come is that ” very clearly, the profitability of insurance carriers has worsened,” says James S. Gamble, a senior manager of the business risk solutions practice of Ernst & Young in New York City, and project manager of the survey, which was based on responses from 719 U.S. executives with responsibility for risk management. (The survey also separately looked at the results of 60 Canadian executives.) “It’s very important to recognize [that property-casualty insurance is] a cyclical industry,” going from soft to hard as insurance company profits worsen, he adds. “It’s time to think about a marketplace that’s not at all friendly.”

Indeed, the fact that about two dozen insurance stocks recently hit 52-week highs partially indicates that Wall Street is betting on a hefty rise in premiums (as well as mergers).

Besides retained-loss costs and insurance premiums, the other expenses included in the overall cost of risk measured by the study, which covers liability, property, and workers’ compensation risks, are those associated with internal risk management and insurance administration; outside risk management services; financial guarantees; and fees, taxes, and similar expenses.

The survey cites figures from Best’s Aggregates and Averages showing a steep three-year-rise in insurance industry operating ratios, which tend to rise as profitability falls. For example, it rose from 87.9 percent in 1997 to 93 percent in 1998 to 97.6 percent last year. (Operating ratio is the sum of expenses and losses expressed as a percentage of premium applying to the part of the policy period that’s already expired.) Insurers like The St. Paul Cos. and Chubb have already responded to the underwhelming profit picture by hiking premiums 10 percent to 15 percent in certain lines of business insurance.

Matthew S. Ponticelli, the risk manager for Baltimore-based RailWorks Corp. and chairman of the research committee of New York City- based RIMS, notes that reinsurers are pressuring carriers to tighten terms and raise rates—a traditional harbinger of hard insurance markets. Reinsurers are saying “the primary markets haven’t been listening to us, [and] they have to listen to us…. We don’t believe their reserves are adequate” to cover their losses, according to Ponticelli.

From a CFO’s point of view, the message is a threatening one: Add a few whopping self- assumed losses to those likely premium hikes, and you’ve added big numbers to your expenses related to risk and insurance. That means that risk managers will have to take a hard look at their companies’ potential losses, and retain risks—but only those risks their companies have the stomach to pay for if they turn into real losses.

To respond to the hardening market, CFOs and risk managers should think about “retaining more risk in the future to maximize the cost effectiveness” of their insurance programs, says Gamble, noting that they can do this by making greater use of their companies’ captive insurance programs and expanding their use of self-insurance.

That’s been the traditional response of commercial insurance buyers when prices go up and the availability of certain lines of coverage starts to shrink—insure more of your risk yourself. But doing that opens corporations up to more extreme upward swings in their risk pictures. The benchmark survey shows how wide those swings can be.

In 1997, 1998, and 1999, the average retained losses per $1,000 of revenue were, for liability, $1.17, $1.62, and $1.20. Similarly, they’ve bumped around in the property area from 34 cents in 1997 to 53 cents in 1998 to 33 cents last year. Only retained losses for workers’ comp remained relatively stable, at $1.57, $1.52, and $1.58 for the same three-year period.

In contrast, premiums didn’t vary as much during those three years, staying low in the soft-market part of the cycle. Liability insurance premiums were at 76 cents per $1,000 of revenue in 1997, rising to 79 cents in 1998, before dropping to 69 cents last year. Property premiums fell a bit in each of the three years: from 59 cents in 1997 to 56 cents in 1998 to a low of 52 cents in 1999. Workers’ comp premiums rose from 36 cents in 1997 to 48 cents in 1998, before falling a penny to 47 cents last year.

Retained losses are “clearly the most volatile component. They don’t change marginally from year to year,” says Ernst & Young’s Gamble. “Insurance [premium] changes tend to be more incremental.”